As expected, the Monetary Policy Committee (MPC) voted to hold rates at 3.75% in June with only one member switching their vote. The data flow since the MPC’s last meeting has had a dovish tinge with a deal in Iran pushing energy prices down and May’s inflation data suggesting that the disinflationary trend was still intact. Therefore, it's likely that rates will remain on hold for the remainder of the year. However, the outlook for energy prices and hence inflation remains uncertain which will ensure the Committee continues with a series of hawkish holds. Members will assert that should second round effects emerge they will act promptly, but we doubt the Committee will actually hike unless inflation goes much higher.

Hawkish hold

As expected, the MPC voted to hold rates with a 7-2 majority. The only member to switch their vote was Megan Greene who joined Huw Pill in voting for a 0.25ppt rise. Greene claimed, ‘we should insure against the possibility of larger second-round effects until we have evidence to determine they are not materialising’. Simply, Greene would rather hike now and cut later were the outlook to improve.

Some of the recent data supports the more hawkish stance. The unemployment rate eased to 4.9% in April, suggesting that the jobs market is more resilient than the MPC initially judged and means there could be less slack than initially anticipated. The MPC also finally acknowledged that private sector pay ex bonuses looks too weak relative to the steer from surveys and is running roughly half a percentage point higher after shifts towards lower-paid employment are accounted for, which added to the Committee’s hawkish view. Additionally, GDP grew by 0.6% in Q1, 0.1ppts more than expected. This supports the hawks’ view that activity is resilient enough to allow the Committee to focus on above target inflation.

However, strong GDP growth quickly reversed in April falling by 0.1% following a period of catch up after Budget uncertainty weighed on activity at the end of last year, which adds to the doves’ case that underlying activity is weaker than Q1 GDP suggests. What’s more, inflation came in below expectations in May, reassuring the Committee that the disinflationary process remained intact in the first few months of the Iran war. Indeed, Alan Taylor, the most dovish member of the MPC, emphasised that inflation would have been at target in recent months if not for the mechanical impact of higher energy prices.

That said, we think Mr Taylor’s argument that “If the conflict resolution holds, and risks diminish, lower rates could be preferred.” is a step too far given elevated inflation expectations, disruption to energy supply chains and leading indicators point to inflation jumping sharply later this year.

All told, the Bank was never likely to hike rates at today’s meeting given that uncertainty is still elevated, inflation came in 0.4ppts below the MPC’s forecast in May and the recent fall in energy prices will give the Committee more time to assess whether second round effects are materialising.

Peace accord means MPC on hold this year

Further ahead, the recent drop in energy prices has materially lowered the risk of rate hikes this year. Indeed, the MPC now sees inflation averaging 3.25% in Q4, down from 3.7% in the MPC’s scenario B, which most members seemed to place the most weight on at the April meeting. We expect the MPC to remain on hold throughout this year despite above target inflation for three reasons.

First, a simple Taylor Rule suggests that interest rates at 3.75% are currently restrictive enough to return inflation to target. What’s more, the jump in market interest rates has pushed up borrowing costs in the real economy. This means the MPC doesn’t have to hike rates to weigh on inflation as markets have already done some of the work for them.

Second, the jump in input costs will squeeze firms' margins and real household incomes, prompting growth to slow to an average of 0.1% per quarter over the rest of this year compared to 0.4% since Q1 2024. Indeed, Governor Bailey, the key swing voter, affirmed that the MPC should be careful about hiking rates given the weak outlook for growth stating that “attempting to bring inflation back to the target too quickly may cause undesirable volatility in output”. Translating that from Central Bank speak, the Governor is clearly worried that hiking rates now could unnecessarily weigh on activity.

Third, the weaker labour market should help to keep a lid on second-round effects from higher energy prices. Slower growth and a sharp rise in input prices means we expect the unemployment rate to peak at around 5.3% in Q4, up from 4.9% currently. This should prevent workers from bidding up nominal wages in response to higher inflation as they did in 2022 when wage growth peaked at over 8%. Granted, the Bank’s agents were concerned that “wage disinflation could slow next year as a result of the conflict”, but we doubt pay pressures will jump significantly given the slack in the labour market and much smaller rise in inflation compared to 2022.

However, the risks clearly remain skewed towards rate hikes. Inflation expectations already looked modestly de-anchored before the outbreak of the Iran conflict as our chart below shows. Inflation expectations may rise further in the coming months as hikes to utility bills and rising food inflation, which are more salient to households, drive much of the uptick in inflation.

Elevated inflation expectations were the main reason why Megan Greene opted for a hike stating that “A proactive hike now... should help anchor inflation expectations”. Even Governor Bailey emphasised that he would only “tolerate” above target inflation on the condition that “inflation expectations remain contained.” In short, if the MPC judge that elevated inflation expectations are likely to prompt firms to start hiking prices and households to attempt to negotiate for bigger pay rises then the MPC will opt to hike.

Ultimately, we think the lower outlook for inflation compared to the MPC’s April meeting has sharply reduced the risk of rate hikes this year and will allow the Committee to remain on hold as it tries to balance a weaker economy with above target inflation. That said, the MPC won’t be able to return to rate cuts until 2027 given the upside risks to inflation and de-anchored inflation expectations.

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